Don't Cry for Shareholders

The focus of much of the mainstream media coverage of the Northern Rock nationalization has been directed towards the fate of the stricken lender’s long-suffering shareholders.

And perhaps rightly so: an equity investment in the bank made only 6 months is now worth about 13 percent of its original value. Shareholders are now concerned that any compensation from the UK Government will erode that even further.

Yet it’s difficult to generate a great deal of sympathy for equity investors – or residual risk holders in the language of insolvency lawyers – for several reasons.

To begin, they’re not the only constituents in the now complicated – and encumbered – capital structure of Northern Rock. The bank has responsibilities to its bondholders, its commercial lenders, its depositors and, it must be stressed, the UK taxpayer and his 57 billion pounds commitment to the ongoing survival of this (nearly) failed enterprise.

Secondly, it’s clear to most objective observers that Northern Rock’s existence as a going concern is entirely predicated on its access to government guarantees.

Without the Treasury’s IOU, the bank couldn’t grow its balance sheet, couldn’t seek short or long-term funding in the capital markets and couldn’t even begin to think about paying a dividend to shareholders.

And finally – and perhaps most importantly – shareholders are fully aware of their position in a company’s ownership: they are the owners. Unlike lenders, whose upside is capped (bonds and loans, after all, mature at par value), equity investors can (in theory) earn unlimited gains.

The benefit of that asymmetric risk/reward, however, is the clear assumption that risk does exist. And in Northern Rock – as in any equity investment - the risks were both clear and properly articulated and have been for some time.

Yes, it’s right and proper that they should be compensated, but their investment has been nationalized in all but name for several months now. The real risk in their investment was that Northern Rock’s business model – funding in the short term in the money markets while advancing mortgages in the long term – could crumble under the natural stress of the markets. Which it duly did.

No government can – nor should – guarantee the success of participants in the capital markets. The Treasury’s mistake, in my view, was to hint at this possibility through its multi-billion life-support of Northern Rock while it scoured the earth for a private buyer.

But when none could be found – and it has to be said that Virgin’s 500 million pounds in cash and capital couldn’t remotely assuage the Treasury’s 57 billion pounds commitment – the apron strings had to be cut.